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Chuck Royce has had this problem before. Returns fall behind the pack, and money starts to flow out of his actively managed
Royce Pennsylvania
Mutual Fund into equity-index funds, bonds, and most recently, exchange-traded funds.

The senior fund manager, 73 years old and regarded as a top small-cap investor, blames the Federal Reserve and its quantitative-easing program for distorting values in the stock market. With assets of $6.5 billion, Royce Pennsylvania (ticker: PENNX) isn't seriously threatened by the mild outflows over the past year; it's mostly frustrated.

"Active managers earn their fees building a long-term performance record through time arbitrage," says Royce, who created his fund firm, Royce & Associates, after acquiring a shell fund in 1972. "Value investors succeed not by chasing relative returns, but by embracing the fundamentals of value investing, finding the strongest, highest-quality companies at the best possible prices," he says. By time arbitrage, he means the ability to discern long-term value—buying a stock before the market reflects that value.

But now, nobody wants to pay for quality, as exemplified by the popular "risk on" trades. "This market and the wide availability of credit rewards the overleveraged operations that have made excessive use of debt," he notes. "It's taken us awhile to understand the destructive effects of quantitative easing."

FOR NEW YORK-BASED ROYCE, investing has always been about following a discipline. Those investors so eager to bolt for funds posting better returns should consider whether their new portfolio managers can match Royce's 30-year record of 11.54% a year as of the end of the first quarter, versus 9.39% for the Russell 2000, or the 11.18% a year he's managed over the past 10 years through May 8, better than 80% of all small-cap funds.

Investors, however, often are more interested in recent history. (Royce has been managing small-cap funds longer than Russell has had its small-cap index.) In the short term, Royce hasn't done as well. For the year through May 8, the fund's 11.22% gain is worse than 81% of the small-cap funds tracked by Morningstar. Year over year, Royce posted a 19.75% rise, well behind the Russell 2000's 24.17% gain. The fund's expense ratio is 0.9%.

It's not the first time Royce has had to struggle for acceptance. The Columbia Business School grad couldn't land a position at a top investment bank or in an elite training program, so he took a post at what's now JPMorgan Chase in its correspondent bank-relations group. It happened to be near the equity-research department. "I guess I wagged my tail enough, so I got accepted into research," he says. He analyzed utility stocks but left with a friend when they got the chance to buy the moribund Pennsylvania fund that a small brokerage firm wanted to shed.

Mike Karstens, founder of Karstens Investment Counsel in Omaha, Neb., and a longtime holder of Royce Pennsylvania, says he doesn't worry about one or two years of underperformance. He has been slowly adding to his Royce holdings of late, and says, "All great managers have periods of underperformance."

A recent study supports Royce's view of high-quality small-caps. Furey Research Partners, an institutional boutique based in Newport Beach, Calif., found that over a 10-year period ended March 31, 2013, the least-leveraged firms in the Russell 2000 gained 48%, while the most highly levered gained only 1.9%. Leverage was measured as net debt divided by equity. The performance record is reversed over the short term. For the year ended March 31, 2013, the least-levered companies in the index gained 5.4%, while the most levered gained 15.8%.

Royce's recipe is to buy stocks based on balance-sheet quality, returns on capital, and earnings stability. Ideally, he can buy the stocks at prices between 30% and 50% below Royce's estimate of intrinsic value.

Royce Pennsylvania

Total Returns*

1-Yr

3-Yr

5-Yr

PENNX

19.75%

13.41%

6.57%

Russell 2000

24.17%

15.68%

7.69%

% of

Top-10 Holdings

Ticker

Portfolio**

Oil States International

OIS

1.1%

Reliance Steel & Aluminum

RS

1.0

Federated Investors

FII

0.9

Helmerich & Payne

HP

0.9

Ethan Allen Interiors

ETH

0.8

Lincoln Electric Holdings

LECO

0.8

Unit Corporation

UNT

0.7

Kennametal

KMT

0.7

National Instruments

NATI

0.7

SEI Investments

SEIC

0.7

Total:

8.3%

*All returns are as of May 8; three- and five-year returns are annualized. ** As of 3/31. Source: Royce Funds; Morningstar; Russell

The fund manager buys slowly into seasoned small-caps that are having trouble meeting quarterly earnings guidance. A recent example was women's clothier
Ascena Retail GroupASNA 2.204081632653061%Ascena Retail Group Inc.U.S.: NasdaqUSD12.52
0.272.204081632653061%
/Date(1438376400344-0500)/
Volume (Delayed 15m)
:
4168963AFTER HOURSUSD12.52
%
Volume (Delayed 15m)
:
82089
P/E Ratio
20.193548387096776Market Cap
2040634943.38532
Dividend Yield
N/ARev. per Employee
100323More quote details and news »ASNAinYour ValueYour ChangeShort position
(ASNA). Its shares dropped almost 20%, to $16.50, between Nov. 28 and Jan. 16, following a poor profit report. Much of the weakness was due to Hurricane Sandy and its aftereffects. "Sooner or later, the distortions will work out of the system, and then quality will show itself," says Royce.

He compares today with tech's zenith: "Right now, we're working our way through a bubble of fear, a mirror to how it was in the 1990s, when we were in a bubble of greed." During the earlier period, Royce's returns also lagged, and he lost customers to soaring Internet and tech funds.

One of Royce's favorites these days has been hit dead-center by the Fed's policies. Prolonged ultralow short-term rates have hurt
Federated InvestorsFII -1.0566480774875258%Federated Investors Inc.U.S.: NYSEUSD33.71
-0.36-1.0566480774875258%
/Date(1438376729252-0500)/
Volume (Delayed 15m)
:
409595AFTER HOURSUSD33.71
%
Volume (Delayed 15m)
:
7914
P/E Ratio
22.624161073825505Market Cap
3527448141.763
Dividend Yield
2.966478789676654% Rev. per Employee
615778More quote details and news »FIIinYour ValueYour ChangeShort position
(FII), which runs about $280 billion in money-fund assets, about 10% of the industry's total. Since the crisis, Federated's stock has bounced between $14.73 and $28, versus a precrisis high of $36.73. The firm has been forced to subsidize fee income to stem more money-fund outflows. Even a half-point rise in short rates would add as much as 37.5 cents to Federated's earnings per share, says an analyst.

Another pick is Tulsa, Okla.-based
Unit CorporationUNT -4.362578768783325%Unit Corp.U.S.: NYSEUSD19.73
-0.9-4.362578768783325%
/Date(1438376435795-0500)/
Volume (Delayed 15m)
:
684966AFTER HOURSUSD19.73
%
Volume (Delayed 15m)
:
20761
P/E Ratio
N/AMarket Cap
994411726.195831
Dividend Yield
N/ARev. per Employee
765987More quote details and news »UNTinYour ValueYour ChangeShort position
(UNT), which has a clean balance sheet and a history of solid returns on invested capital. But the stock has ranged between $36 and $62, well below its precrisis high of $88. Royce believes the market has applied a "conglomerate" discount to the company because it operates in three discrete parts of the energy business.

Royce finds these companies with the help of several experienced portfolio managers. Whitney George has spent 21 years working with Royce; Buzz Zaino is a turnaround expert who looks for bargains; Charlie Dreifus analyzes companies' accounting integrity and is a disciple of Baruch College's accounting guru Abe Briloff; and Jay Kaplan tracks top-performing small-caps. Royce is well known for its collegial atmosphere and low turnover.

One of money management's toughest tests is sticking to a strategy that, in the short term, is underperforming. Morningstar has dubbed Royce's recent returns "uninspiring," and one of its analysts notes that Royce has been hurt by avoiding bank stocks, utilities, and real-estate investment trusts. But if you think the Fed will raise rates in the next year or two and that a high-quality balance sheet will count for more, then Royce could be a wise bet.